Rising rates increase the chance of a property crash

Brenda McKinley has been selling homes in Ontario for more than two decades and even for a veteran, the last few years have been impressive.

Prices on his plot south of Toronto have risen as much as 50 percent during the pandemic. “Houses were selling almost before we could get the sign out on the lawn,” he said. “It was not unusual to have 15 to 30 offers. . . there was a feeding frenzy.”

But in the last six weeks the market has changed. McKinley estimates that homes have lost 10 percent of their value in the time it would take some buyers to complete their purchase.

The phenomenon is not unique to Ontario or the residential market. As central banks raise interest rates to curb runaway inflation, real estate investors, homeowners and commercial landlords around the world are asking the same question: Is a crash brewing?

“There is a marked slowdown everywhere,” said Chris Brett, head of capital markets for Europe, the Middle East and Africa at real estate agency CBRE. “The change in the cost of debt is having a huge impact on all markets, on everything. I don’t think anything is immune. . . speed has taken us all by surprise.”

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Publicly traded real estate stocks, closely watched by investors for clues as to what might eventually happen to less liquid real assets, have tanked this year. The Dow Jones US real estate index is down nearly 25 percent so far this year. UK property shares fell around 20 percent over the same period, falling faster and faster than their benchmark.

The number of commercial buyers actively seeking assets in the US, Asia and Europe has fallen sharply from a pandemic peak of 3,395 in the fourth quarter of last year to just 1,602 in the second quarter of 2022, according to data from MSCI.

Pending deals in Europe have also decreased, with €12 billion in contracts at the end of March compared with €17 billion a year earlier, according to MSCI.

Offers that are already in progress are being renegotiated. “All those who sell everything are being [price] chipped by potential buyers, or [buyers] they are leaving,” said Ronald Dickerman, president of Madison International Realty, a private equity firm that invests in real estate. “Anyone who subscribes [a building] is having to reevaluate. . . I cannot overemphasize the amount of repricing that is occurring in real estate right now.”

The reason is simple. An investor willing to pay $100 million for an apartment block two or three months ago could have taken out a $60 million mortgage with borrowing costs of around 3 percent. Today they might have to pay more than 5 percent, erasing any advantage.

Rising rates mean investors must either accept lower overall yields or pressure the seller to lower the price.

“It’s not showing up in broker data yet, but there is a correction, anecdotally,” said Justin Curlow, global head of research and strategy at Axa IM, one of the world’s largest asset managers.

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The question for property investors and owners is how widespread and deep any correction might be.

During the pandemic, institutional investors played defensively, betting on sectors supported by stable long-term demand. The price of warehouses, rental apartment blocks and offices outfitted for life sciences businesses soared amid fierce competition.

“All the big investors sing the same score: they all want high-quality residential, urban logistics and offices; defensive assets,” said Tom Leahy, head of real asset research for MSCI in Europe, the Middle East and Asia. “That’s the problem with real estate, you have a herd mentality.”

With cash falling into the tight corners of the housing market, there is a danger that assets will be mispriced, leaving little room to erode as rates rise.

For owners of “defensive” properties purchased at the top of the market who now need to refinance, the rate increases create the potential for homeowners “paying more for the loan than they expect to earn on the property,” Lea said. Overby, commercial director. mortgage-backed securities research at Barclays.

Before the Fed started raising rates this year, Overby estimated, “zero percent of the market” was affected by so-called negative leverage. “We don’t know how much it is now, but anecdotally it’s pretty widespread.”

Manus Clancy, senior managing director of New York-based CMBS data provider Trepp, said that while stocks are unlikely to crash in the more defensive sectors, “there will be a lot of guys who will say ‘wow, we overpay for this'”.

“They thought they could raise rents 10 percent a year for 10 years and expenses would stay flat, but the consumer is being hit by inflation and they can’t pass on the costs,” he added.

If investments considered safe just a few months ago seem precarious; The riskiest bets now seem toxic.

The rise of e-commerce and the shift to hybrid working during the pandemic left office and store owners exposed. Rising rates now threaten to bring them down.

An article published this month, “Working from home and the office real estate apocalypse,” argued that the total value of New York offices would eventually fall by almost a third, a cataclysm for owners, including pension funds and government agencies that depend on your taxes. income

“Our view is that the entire office stock is worth 30 percent less than it was in 2019. That’s a $500 billion hit,” said Stijn Van Nieuwerburgh, a professor of real estate and finance at Columbia University and one of the authors of the report.

The fall has not yet been registered “because there is a very large segment of the office market (80-85 percent) that is not listed on the stock exchange, is very non-transparent and where there has been very little trade,” he added.

But when older offices change hands, when funds reach the end of their useful lives or owners struggle to refinance, expect the discounts to be severe. If values ​​fall far enough, he anticipates enough mortgage defaults to pose a systemic risk.

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“If your loan-to-value ratio is above 70 percent and your value drops 30 percent, your mortgage is underwater,” he said. “Many offices have more than 30 percent mortgages.”

According to Curlow, up to 15 percent of the value of US offices is already being eliminated in the final offers. “In the US office market, there is a higher level of vacancies,” she said, adding that the United States “is ground zero for rates; it all started with the Federal Reserve.”

UK office owners are also having to deal with changing work patterns and rising fees.

So far, homeowners with modern, energy-efficient blocks have done relatively well. But rents for older buildings have taken a hit. Property consultancy Lambert Smith Hampton suggested this week that more than 25 million square feet of office space in the UK could exceed requirements after a survey found that 72 per cent of respondents were looking to reduce office space as much. soon as possible.

Hopes have also faded that retail, the most disadvantaged sector among investors heading into the pandemic, could enjoy a recovery.

Big UK investors, including Landsec, have bet on shopping malls over the past six months, hoping to take advantage of a pick-up in retail as people return to brick-and-mortar stores. But inflation has derailed the recovery.

“There was this hope that a lot of mall owners had that there was a level to rents,” said Mike Prew, an analyst at Jefferies. “But the cost-of-living crisis pulled the rug out from under them.”

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As rates rise from ultra-low levels, so does the risk of a reversal in residential markets where they have been rising, from Canada and the US to Germany and New Zealand. Oxford Economics now expects prices to fall next year in those markets where they rose fastest in 2021.

Numerous investors, analysts, brokers and owners told the Financial Times that the risk of a drop in property valuations had risen sharply in recent weeks.

But few expect a drop as severe as the one in 2008, in part because lending practices and risk appetite have moderated since then.

“Overall, it looks like commercial real estate is ripe for a recession. But we had strong growth in Covid, so there is room for it to deviate before it impacts anything. [in the wider economy]Overby said. “Before 2008, leverage was 80 percent and many valuations were bogus. We are not there at all.”

According to the director of a large real estate fund, “there is definitely stress in the smaller pockets of the market, but that is not systemic. I don’t see many people saying. . . “I committed to a €2bn to €3bn acquisition using a bridging format,” as happened in 2007.”

He added that while more than 20 companies seemed precarious in the run-up to the financial crisis, this time there were perhaps five.

Dickerman, the private equity investor, believes the economy is poised for a long period of pain reminiscent of the 1970s that will send real estate into a secular decline. But there will still be winners and losers because “there has never been a time in real estate investing when asset classes are so differentiated.”

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